I am, generally, a big fan of Robert Higgs, but I have some quibbles with this analysis (though this analysis is common among other people I like).

Higgs outlines his arguments in a blog post here. His main argument is that

Since late December 2008, the bank prime lending rate — the interest rate banks charge their best corporate customers — has remained steady at 3.25 percent. . . Meanwhile, during the same period, the excess reserves that commercial banks hold at the Fed have increased from $2 billion in August 2008 to $1,513 billion in May 2011. [He has the quite striking graphs to go with it.] Ordinarily, one would have expected this development to produce hyperinflation of the general price level. However, the price level has increased quite moderately, and for a while many analysts warned that deflation was the greater risk.

In short, I think Higgs has hyperinflated the hyperinflation concerns on the reserves question. I think the effect of the allowing the Federal Reserve to pay interest on reserves is overblown and much less of a factor in an alleged increase in (onshore) reserves.

Regarding my first point, for a long time, money center financial institutions (and later smaller ones) used "sweeps" software to "sweep" their deposits overnight from the US (to avoid the reserve requirements which didn't pay interest) to offshore havens where they got a higher rate of return--and back again the next morning (consumers never knew). Companies followed the capital markets dictum that "money goes where it's welcome and stays where it's well treated." Our bad policies here forced our money offshore. By removing some bad laws here (prohibition on paying interest on reserves), some of the reserves that went offshore now stay onshore (Higgs has a dramatic graph of this). But I question just how great the increase in overall reserves (domestic and what used to get swept offshore overnight) has been and how much of the dramatic graph can be explained by the marginal change from keeping on deposit at the Fed reserves that previously had been swept offshore.

Higgs' second main point with which I question is his contention that there is something fishy about banks not lending to their best corporate customers for a greater return on their money:

Moreover, they are doing so notwithstanding that they appear to have the option of lending at 3.25 percent to their best corporate customers and at higher rates to their less creditworthy customers. Why are they forgoing the opportunity to earn huge sums by switching out of excess reserves at the Fed into commercial loans and investments? The answer would seem to be that that are so frightened of the risk associated even with loans to their best customers that they are loath to lend.

But again I think he fails to put the issue in a greater context: companies are hoarding cash in record numbers. According to CNBC, the "best corporate customers" for the banks in Higgs' examination are sitting on a record hoard of $800 billion themselves. Why would they be beating down the doors of the banks to borrow more money? Explains the CNBC article:

The current members of the S&P 500 are sitting on about $800 billion in cash and cash equivalents, the most ever, according to data by Birinyi Associates, even as the unemployment rate has ticked back above 9 percent. Most of this cash and cash equivalents are likely yielding at or below the current 3.6 percent annual rate of inflation, giving it a negative real return.

So why would any profit-seeking corporation go to one of Higgs' banks with "excess" reserves and borrow at 3.25% when it is already hoarding record cash? Is the Fed just "pushing on a string?" More importantly, the question is not as Higgs alludes ("The answer would seem to be that that are so frightened of the risk associated even with loans to their best customers that they are loath to lend.") but one that needs to go to the unwillingness of creditworthy businesses to invest.

The CNBC article implies that companies are not hiring because there is no demand. This raises questions about economic theory. Some Rothbardians might argue that any increase in the money supply (and I'm purposefully trying to generalize on people and terms here) is inflationary while others even in the Austrian school (generally those on the free banking side unconcerned with the full reserve question) have said that under non-governmentally regulated market conditions (certainly not what we have now), money supply increases would (generally) match market demand for new money. I posit that the question Higgs tries to answer wrestles with this question.

I would welcome comments, insights, corrections and importantly better numbers on aggregate US bank reserves including marginal changes in aggregate sweeps.

2 Responses to “Hyperinflated Hyperinflation Reserve Concerns”

Scott Sumner has maintained that the Fed continuing to pay interest on reserves has been contractionary. If the Fed charged a 25bps rate on excess reserves, it would likely result in faster expansion of broad money supply.

Here's a useful question (I'm not sure of the answer), why don't the corporations buy back shares or issue dividends? The cost of debt is likely low enough to make it more attractive to rely on debt financing than equity.

I sort of agree with Sumner on this point. THe reason why Professor Higg's explanation fails is because he doesn't look at reserve requirements for various kinds of assets(loans issued) on banks balance sheet. Loan to fed, which is considered cash, is what constitutes the reserves held at the fed. This has 0 reserves needed. ROE on these loans are infinity. Banks have no incentive to lend money so long as Fed pays +ve interest on reserves. I explain this here.